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Thursday, 22 January 2015

The Beauty of Compounding in Companies and Its Implications

In my previous post on The Beauty of Compounding to Investors, I've discussed briefly on the mechanics of the simple compound interest equation and concluded that the best way for an investor to optimize its use is to identify each factor (starting capital, compound rate, time period) in the equation separately and work on the weaknesses (especially those that is easily within our control) so that the integration of all 3 factors can hopefully produce an exceptional result. In this post, I'll talk more about this effect on companies and try to relate it to the individual investor.

Case Studies & Assumptions

Let's use some of case studies for Company X (if you are curious about the company's real identity, like me on Facebook or follow my posts via email by subscribing on the right panel - Let me know by commenting below or emailing me at secretinvestors@gmail.com when this is done). As usual, to make things simple, some assumptions have to be made for the model:

In the actual case, Company X managed to grow its book value by compounding it at >10% annually for the past 12 years. Here, we assume that this growth rate will continue for the next 5 years. Book value now is $0.25 per share.

Assume book value is a reasonable estimate to intrinsic value of the company and the market price of its stock will converge to its intrinsic/book value at the end of 5 years.

No other forces (inflation etc) are at play that will skew the final results.

4 scenarios will be used here (please note again that book value for all scenarios is $0.25 per share):

Summary of Scenario Results

Scenario Capital Appreciation Results (Dividends not factored in)

Comparing Scenarios A & B, we see that despite paying at 20% premium to book value (for B), the stock investor is still able to turn in better results compared to one who bought at 20% discount to book value (for A) - provided the growth rate is high enough. In this case, a quick calculation shows that a 4.5% growth rate in Scenario B is sufficient to get the same 25% results achieved in Scenario A.

Comparing Scenarios C & D, it is clear that although the purchase price of D is only 20% lower than C and both have the same growth rate, D turns it significantly higher results (much more than 20%). All in all, Scenario D gives the best results. For your info: Company X is currently priced below that of Scenario D now, indicating a better upside if we were to base it on this very simplistic model.

This is a very simplistic view of the compounding effect but it does show the powerful snowballing effect of the compound equation. The key limitations are obviously in the assumptions. In the first place, we can't know for sure whether the book value or 'intrinsic' value can grow at 10% for the next year, save to say for 5 straight years. Also, there are definitely many other factors or uncertainties at play that will affect the final result. Lastly, for most companies, the book value does not equate to the intrinsic value. Even if they do, the market price may or may not converge to this implied intrinsic value at the end of 5 years (it could be earlier or later). Despite these limitations, I believe its good enough to show the compounding effect and its implications to the stock investor.

The Ultimate Approach - Dual Margin of Safety

Margin of safety is an important part of our overall investment framework as discussed in the post on Our Stocks Investment Philosophy. The above exhibit suggests 2 key ways to profit from the stock market. First and foremost, the investor can purchase securities at a price that is currently at a discount to a readily ascertainable intrinsic value as in Scenario A. This discount is in itself a margin of safety. Alternatively, the investor can purchase the security at a reasonably fair price as compared to the current intrinsic value but he or she must be confident that the future prospects or growth is so good that it is sufficient margin of safety for a profit to be made, as in Scenario C above.

The best approach to stock selection is of course to find securities that meets both criteria or approaches discussed in the previous paragraph - by having a discount to current value and potential growth that can further increase this value in the foreseeable future such that the cushion in price-value gap widens further over time. This is similar to Scenario D in the above table which as shown, give the best results out of the 4.

I will discuss further about the obstacles in execution in the application of the Dual Margin of Safety approach and end off with my proposed solution. Let me know if there's alternative methods or approaches that you've been doing that has been consistently successful ya?

Disclosure:

Long Company X - Do you know which company is this?

As mentioned, if you are curious about Company X's real identity, like me on Facebook or follow my posts via email by subscribing on the right panel - When this is done, let me know by commenting below or emailing me at secretinvestors@gmail.com :-)

Totally agree with you. These are just simple models for us to get a general idea of how things works but in practice other forces, both known and unknown, will cause the results to deviate from theory. In my proposed solution, I'll try to make things as practical as possible but obviously it won't be perfect :) Thanks!

It's interesting though that you actually used the book value as a measurement of growth. I thought book value growth is much harder to achieve than earnings growth as it covers a wider spectrum. It is like earnings is the subset of that.

Thanks for your encouragement. Always a pleasure to discuss with you about investments and the like.

I used book value in this case because it's easier for me to explain the compounding effect. Also, unlike earnings and cashflows, book value is less subject to fluctuations with time and thus more predictable for use. Besides these, book value is highly related to earnings - A consistently growing book value usually indicates healthy earnings over the period since whatever is left in net income after deducting dividends goes to the book. Lastly, we can also view book value as a rough gauge to the company's intrinsic value if it is to be a liquidated. This means that using book value is not wrong although it may not be the best choice in the end.